Is This a Golden Age of Fraud?

A podcast about how "passive income" money-making scams seem to have taken over the internet, and the economic implications of such scams.

Patrick's Books:
Statistics For The Trading Floor:  https://amzn.to/3eerLA0
Derivatives For The Trading Floor:  https://amzn.to/3cjsyPF
Corporate Finance:  https://amzn.to/3fn3rvC

Patreon Page: https://www.patreon.com/PatrickBoyleOnFinance
Buy Me a Coffee: https://buymeacoffee.com/patrickboyle

Visit our website: www.onfinance.org
Follow Patrick on Twitter Here: https://twitter.com/PatrickEBoyle

Patrick Boyle YouTube Channel

Transcript

Last year the Federal Trade Commission reported that consumer losses to fraud had grown 30%.  The prior year reports of fraud had grown 16.3%. Apparently the biggest losses were to investment scams, including cryptocurrency schemes.

Younger adults in their twenties reported losing money more frequently than older adults. But when older adults did lose money, they lost a lot more, and that makes sense as older adults tend to be wealthier, but hopefully a bit wiser.

It’s not just an issue in the United States either, UK banks reported a large increase in fraud in 2022, with much of it originating online.  

When I interviewed Zeke Faux a few weeks ago he described how he had initially resisted looking into crypto fraud, as he felt that a journalist spending time investigating a crypto scam was like a restaurant critic writing a review on a new Taco Bell that had just opened up. When he started investigating, he quickly realized that there was so much fraud going on that he wouldn’t have time to document it all.

When I first spoke to Coffeezilla a few years ago, he told me at the time who he thought the biggest scammers out there were, and wondered what he might do with his YouTube channel once he had finished exposing them.  Since that point, the scammers he has found have only gotten bigger, many are celebrities, and they don’t even appear to make much of an effort to disguise what they are up to anymore. Based on the latest fraud statistics, it doesn’t look like he will be running out of work anytime soon.

There is nothing new about scamming, and the way most of today’s scam’s function isn’t really new either, most are simple Ponzis and pyramid schemes, but has something changed in recent years where with the growth of online hustle bros, and celebrity involvement in many of these schemes, people seem to possibly view it as being acceptable – or even high status to scam people?

It is hard to go online without being pitched scam content about using Chat GPT to trade stocks or an endless variety of passive income schemes, that are extremely unlikely to actually work out for you.

This summer an AP analysis found that fraudsters potentially stole more than $280 billion dollars in pandemic relief funding.  Criminals and gangs grabbed some of the money, but so did a U.S. soldier in Georgia, the pastors of a defunct church in Texas, a former state lawmaker in Missouri and a roofing contractor in Montana. The fraud was widespread.

Much of the theft was simple and fairly obvious.  Scammers used the identities of dead people and federal prisoners to get unemployment checks, often collecting them in multiple states. 

The Small Business Administration estimates fraud in two of their programs at over 100 billion dollars. The names of celebrities’ entertainers and CEO’s can be found on the list of those charged. The SBA are overwhelmed with investigations and say that they are dealing with a backlog of more than 80,000 actionable fraud leads, which is close to a 100 years’ worth of investigative work.  The disturbing thing about the story was how many ordinary people decided to turn to fraud during the pandemic.

The hedge fund manager Jim Chanos argues that we are living through a golden age of fraud. He believes that the fraud cycle follows the business and financial cycle, and that at market peaks, there is the most fraud going on in an economy which is only exposed once there is a downturn.

There is some evidence to support his claims.  The most widely held securities in America during the 1920’s were the stocks and bonds of Kreuger and Toll a Swedish Match conglomerate. The reason people invested was that the securities were sold in small denominations and paid high dividends of over 20%.  The dividends were being paid out of capital, rather than profits. The business was essentially a giant Ponzi scheme. It’s bankruptcy in 1932 led to the introduction of securities regulation in the United States.

In these fraud cycles, law enforcement always arrives late, and new regulations are put in place after the event.  Fraud was uncovered at firms like Enron and Worldcom after the dot com bubble burst, and all sorts of fraud was discovered after the global financial crisis in 2008. In each case law enforcement turned up late too late to protect the public and then policymakers followed up with new regulations.

There is a wide range of what people think of as scamming.  It ranges from over-promising and under-delivering to fraudulent PPP loans to large scale Ponzi schemes like Bernie Madoff ran.

YouTube gurus like to pitch all sorts of passive income scams, promising massive returns in a short period of time. These schemes often involve multi-level marketing, where participants are encouraged to recruit others, or they involve buying an overpriced course from someone who makes all of their money selling courses rather than by following the passive income scheme that they are pitching to their viewers.  

These scammers usually chase whatever is hot at a given point in time claiming to be experts in dropshipping, cryptocurrencies, web 3 and today AI, where they will tell you how they turned $100 dollars into a million dollars in a month getting stock tips from ChatGPT. An AI Autocomplete chat bot…

Passive income doesn’t really exist.. the vast majority of these passive income strategies are at best misrepresented and at worst completely fabricated to prey on the financially desperate.  The most likely outcome when you sign up for any of these courses is that you will learn nothing and be down the thousands of dollars you spent on the course fees.

Some of them offer access to their stock pics behind a paywall, which is unlicensed financial advice – despite what their disclaimers might say - and I have been told that the SEC is investigating this sort of thing right now.

The type of things that influencers pitch as being passive income are usually either investment income or some form of self-employment.  To make money investing, you usually need money to start with, and if it is going to replace your job, you should probably start with over a million dollars, so the best way to earn a passive income through investment if you are young is to choose your parents wisely.

To describe being self employed as earning passive income is so ridiculous that it barely seems worth addressing.  Small business owners work hard, and how hard they work might even surprise some of you. A survey from “New York Enterprise Report” found that small business owners work twice the hours of the average wage earner.  Building a business is not passive income, and most founders earn nothing in the first year of their startup and the majority of small businesses fail in their first year.  It’s not easy, and shouldn’t be represented as such.

A recent video by Tom Nicholas argued that a lot of today’s passive income scams can be traced back to the publication of Tim Ferriss’s book the four-hour workweek in 2007.  The book came out right as the financial crisis was hitting and spent four years on The New York Times Best Seller List, was translated into 40 languages, and sold over two million copies.  It was influential…

While Ferriss didn’t pitch a get rich quick scheme, it can be argued that he pitched a get rich easy scheme.  It was right there in the title.  You only needed to work four hours a week if you followed his recipe for success.

The financial crisis put a lot of people out of work, and the jobs that were lost were middle income roles, which people often replaced with lower paid service sector jobs and side hustles. The four-hour week really spoke to this group who felt that they could possibly earn more money while working fewer hours.

Ferriss pitched that people could convince their employer to let them work from home and then earn passive income through drop shipping, affiliate marketing, retail arbitrage or by “teaching courses”.  The same list of passive income strategies being pitched by online scammers today.  He was criticized at the time for advising people to become “fake experts” and The New York Times noted that Ferriss spent far more than 4 hours a week blogging and promoting his book.

Tim Ferriss made his first big money selling “brain pills” on the internet (or nutritional supplements) while working a full-time job.  He was working eighty hours a week according to a profile on the Princeton University website. Once the Four-Hour Workweek took off, he sold the “brain pill” business (I guess he got tired of the passive income) and mostly makes his money now through book sales and as a self help guru.  

A lot of his ideas are based on the Pareto principle which states that for many outcomes, roughly 80% of consequences come from 20% of causes.  He argued that you only needed to focus on the most important levers and could ignore or outsource most of your work, which is wasted effort anyhow.

Of course, he left out that you only know after the event which of the seeds you planted didn’t grow.  Most people are not wasting most of their workday on unnecessary activity.  If only twenty percent of an engineer’s designs turn out to be valuable, it doesn’t mean that they foolishly decided to waste eighty percent of their time designing products that don’t work.  You sometimes have to do the stuff that doesn’t work in order to find the stuff that does.

Ferris’s pitch in the four-hour work week was that you could create an automated vehicle for generating cash without consuming much time. This idea provided a lot of the inspiration to the passive income scammers, who unable to generate passive income for themselves decided to become “fake experts” or what Mike Winnett calls contrapreneurs selling get rich quick schemes to the public with the aid of a rented Lamborghini and bundles of fake cash that can be bought on Amazon.

There were many effects of the financial crisis of 2007-2008. It led to the occupy Wall Street movement and the Tea Party movement. Both of these were driven by the idea that everything was rigged and rigged in someone else’s favor.  People were angry about the unfair nature of the bailouts, and the rise of things like cryptocurrencies, and meme stocks can be traced back to the anger the public felt in the wake of the credit crunch.  Unfortunately putting money into many of these “alternative investments” led to the public being harmed - once again - as insiders cleaned up.

Jim Chanos argued in a recent interview that aggressive accounting by companies is at an all time high, in particular he highlighted abuses by Silicon Valley companies releasing accounts with tens of pages of adjustments which they highlight instead of the GAAP numbers. Many of these companies use share-based compensation in order to hide how unprofitable they are by claiming that employee compensation is not an expense.  Many of these companies will issue press releases saying that they are now profitable on an adjusted basis, but when you dig into their accounts it is clear that they are still losing money.  Many of the worst offenders on this front are the most popular stocks amongst retail investors, and the most promoted by finfluencers on YouTube.

Investors would probably be wise to avoid paying any attention to those who claim to analyze stocks on social media.  YouTubers make money from getting views on their videos, not from picking the best stocks, thus their incentive is to discuss the hottest stocks of the moment, not the stocks they believe will make the best investment for their viewers. That is why they promoted meme stocks, spacs, various dog themed crypto currencies, and using chat bots to pick stocks, these videos get clicks. If they had a great investment idea, but on a boring sounding stock, they wouldn’t make a video.  

Tom Nicholas makes an interesting point near the end of his video about the rise of the online grifter and why you see them everywhere.  He argues that most of these people are probably not making that much money, but they see how society looks up to Silicon Valley founders, and they want to appear to their friends to be just like their heroes.  They try to dress like, speak like and take on the routines of the super-rich as they think of this as high-status behavior.  They are roleplaying as jet set startup founders as they think this will impress people and take them somewhere in life.

In his book The Great Crash 1929, John Kenneth Galbraith introduced the term bezzle. He derived the word from embezzlement, which he called “the most interesting of crimes.” He explained that weeks, months or years might elapse between a crime being committed and its discovery. During this period, both the criminal and the victim feel wealthy - as the embezzler has his gain and the man who has been embezzled, - so far - feels no loss.

Galbraith calls the embezzled wealth “the bezzle” which at any moment in time in an economy can amount to a huge (if unknowable) sum of money.  There are some good recent examples of this like when earlier this year JP Morgan discovered that 54 metric tons of nickel that it thought it owned in a warehouse in Rotterdam turned out to be bags of stones.  Similarly, when people have their money invested in a Ponzi scheme, they feel wealthy when the statements showing huge returns arrive in the post, they go out and spend like they are wealthy not realizing that it is all an illusion.  The scammer, on the other hand, knows that he has stolen their money and spends it freely too.  Maybe even buying a Lamborghini and taking some real hundred dollar bills out of the bank, rather than the fake ones Grant Cardone burns to impress teenagers on the internet.

The economist John Kay wrote of how the champagne that Enron’s Jeff Skilling drank when the SEC allowed him to mismark energy contracts was paid for by the company’s shareholders and creditors, but they would not know that until ten years later. He describes how households in US cities received mortgages in 2006 that they could never hope to repay, while taxpayers never dreamed that they would be called on to bail out the lenders. Shareholders in banks could not have understood that the bank dividends they received before 2007 were actually money that they had borrowed from themselves.

Of course, the Bezzle always disappears when the fraud is discovered.  Hyman Minsky explained, that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.” Because the bezzle is, by definition, temporary, at some point the bezzle will be eliminated, and its elimination will reverse the earlier boost to the economy. When that happens, what appeared to be a virtuous cycle becomes a vicious cycle.

Michael Pettis adds to this that the bezzle doesn’t have to vanish as soon as it is discovered.  It can also be eliminated much more slowly, as the gap between reality and the growth expectation implicit in the price of an asset is slowly amortized. When this happens, the loss associated with the bezzle is effectively eliminated through (often hidden) transfers that force the loss onto one economic sector or another. Regulators, he points out, might bail out the losers—especially if they threaten the banking system—and governments might then raise taxes to cover the bailout or distort interest rates in ways that allow banks to profit artificially at the expense of depositors and borrowers.

He gives the example of how Chinese regulators in the early 2000s effectively amortized the bezzle buried in the bad debt on the balance sheets of the country’s banking system by setting deposit rates so far below nominal GDP growth rates that banks and insolvent corporate borrowers could, just by rolling over the debt for ten years or more, reduce the real cost of the debt by more than an estimated 50–60 percent. Those losses were recouped by the banks that had funded the loans in the form of very low deposit rates.

This sort of thing is by no means restricted to China. When this happens, it is mainly ordinary households who pay for the reversal of the bezzle, either directly through taxes or indirectly through repressed deposit rates or even unemployment.

There are all sorts of things that can create a bezzle in an economy, outright fraud, like with a ponzi scheme, asset price bubbles, malinvestment – where nonproductive economic activity can give the impression of wealth creation, but the foolish investment never pays off as it never made sense to begin with.  

The way Pettis describes it, the bezzle represents recorded or perceived wealth that does not actually exist as real wealth (or productive capacity), and as such it boosts collective recorded wealth above real economic wealth – until of course it is discovered.

The bezzle cant be quantified or even proven to exist until after the fraud has been discovered, making it a difficult concept for economists who seek precise numbers for their analysis, but if fraud and scamming are really growing at the rates described by the Federal Trade Commission report, eventually the chickens will come home to roost.  As Pettis points out in his excellent piece on this topic, you can’t know who will be faced with the bill for a fraud – especially if the bill gets large enough, as governments then decide how to allocate the loss.

Bull markets can lead to complacency and sometimes even gullibility. When asset prices fall - a lot of fraud is often uncovered. This was the case after the 1929 crash, after the Savings & Loan Crisis, after the dot com bubble burst and after the credit crunch. Crypto scammers are only beginning to be rounded up now after the collapse of FTX.

As an investor you should aim to be most vigilant at times of market excess when you see others rushing in worried that they will miss the party. As John Mills wrote in 1867: "Panics don’t destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works." 

Hopefully the statistics of growing fraud released by the FTC don’t indicate a real increase in fraudulent activity in the economy, and instead reflect its discovery as some of the froth has disappeared over the last year as in general, economies grow faster, and life is more pleasant the more that individuals can trust each other. 

Thanks for tuning in to this week's podcast, if you enjoyed it I would love if you could write a short review on whatever podcast app you are using to help the podcast grow.  Have a great week and talk to you again soon.  Bye.